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At Schwab, Unkept Promise To Investors

Claiming to be holier than thou is not a prescription for winning friends among the thous. But it can be an effective marketing strategy in a business where public confidence is less than solid.

On Wall Street, nobody has used that strategy better than Charles Schwab & Company. Eight years ago, when research analyst conflicts were in the news, Schwab ran a television commercial that memorably showed a manager at a rival brokerage firm promising “courtside playoff seats” to his brokers, but only if they “put some lipstick on this pig.”

On Schwab’s Web site now is a letter from Charles Schwab, the founder and chairman, proclaiming: “I made a commitment. I’m on the side of the investor.” For 30 years, he says, “we’ve kept our clients’ interest as our main focus, creating a true Wall Street alternative for all investors.”

It turns out that Schwab did not live up to those promises during the financial crisis, for which it agreed this week to pay $119 million to the Securities and Exchange Commission and other regulators, most of which will go to investors who bought into Schwab’s marketing hype for a fund full of risky investments that was promoted as a safe way to do better than a money market fund.

It may be debatable whether Schwab lied to investors about the fund. But it is clear that it misled them about a crucial aspect of the fund’s investments. As the financial crisis was growing, Schwab decided that a security’s maturity was not, as it previously said and as any normal person would think, the date a security was scheduled to mature. Instead, it decided that a security that would mature in 20 years, but whose interest rate was reset every month, had a one-month maturity.

To notice the change had been made, an investor would have had to be a very, very careful reader of financial statements. But even that reader would have had no way to figure out the impact of the change, which turns out to have been huge.

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Companies that settle with the S.E.C. neither admit nor deny the commission’s allegations. But they seldom are as eager to point the finger of blame elsewhere as Schwab was. There was no hint of remorse that the fund had concentrated fund assets far more than it had told investors it would, or that it had made numerous misleading statements when the fund was crashing.

“The decline in the YieldPlus fund was the result of an unprecedented and unforeseeable credit crisis and market collapse. Until the credit crisis, the YieldPlus Fund was consistently one of the top performing funds in its category for eight years.”

And it wants us to know who the real villains are. Holier-than-thou is back:

“To provide future protection for individual investors from similar market crises, the company hopes that greater focus and attention will ultimately be given to the investment banks that created mortgage-backed securities and the ratings agencies that legitimized them with triple-A ratings, which have so far largely escaped scrutiny and accountability.”

Goldman Sachs, which paid $550 million to the S.E.C. after being accused of violating securities laws in putting together a particularly egregious mortgage-backed security, would no doubt be interested to know that it has “so far largely escaped scrutiny and accountability.”

In one way, Schwab has a point. Almost everyone connected with the credit bubble acted badly. But surely investment managers who promise to be different could show a little contrition about the fact that a fund they vigorously marketed as “a cash alternative for investors” lost nearly half its value.

A more reflective person than Mr. Schwab seems to be would long ago have figured out what went wrong at YieldPlus. It was the same things that let the fund seem to be a star performer for so many years. It took more risks than similar funds, and in good times such risks are rewarded.

Perhaps the biggest risk Schwab was taking was one that investors could not have known about. The S.E.C. states that in mid-2007, only 6 percent of the fund’s assets matured within six months. That was critical. It meant that when liquidity dried up in the credit crisis the fund had few securities that it could simply allow to mature. Instead, it had to sell assets for whatever it could get. In a lot of cases that was not very much.

And it did have to sell rapidly. At the end of June 2007, according to Morningstar, the fund had $13.5 billion in assets. A year later, 95 percent of those assets were gone. Some of that was because of the market — investors who stuck it out lost almost a third of their money. But most of it was because of withdrawals by investors who were not getting what they bargained for.

That maturity risk would have been obvious to anyone who understands bonds. But if an investor was worried about that, the 2007 annual report was reassuring. It said that on Aug. 31 of that year, more than 60 percent of the fund’s assets had maturities of six months or less. In the glossary at the back of that annual report, maturity was defined to mean just what it really means: “The date a debt security is scheduled to be ‘retired’ and its principal returned to the bondholder.”

But that was not what Schwab really meant. At the beginning of the list of investments held by the fund, it said that the maturity date shown for adjustable rate securities was “the next interest rate change date.” That was not what the fund had said in the previous year’s report, and I could not find anywhere that the fund called attention to the change.

Looking at the list of securities, there was no way for an investor to learn the actual maturity of each security.

The change made the fund look as if it would be much less vulnerable to a liquidity crisis than it actually was. You might even say that the adroit alteration of meaning “put some lipstick on this pig.”

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Charles Schwab, the founder and chief executive of Charles Schwab, spoke at the grand opening of a branch in San Francisco.Credit
Justin Sullivan/Getty Images

Schwab continued that misleading disclosure in the 2008 and 2009 annual reports, although it did change the glossary to disclose its creative definition of maturity. Finally, in the 2010 report it gave the actual maturity date of each security.

Schwab’s holier-than-thou statement does not address the maturity issue at all. Nor does it comment on the fact that the S.E.C. charges that some Schwab entities, including a fund that was invested in other Schwab funds, chose to bail out of the fund knowing that redemptions were piling up at a time when the fund was saying they were small.

But it does say that Mr. Schwab himself was the largest investor, and the largest loser, when the fund cratered.

Two top Schwab executives refused to settle S.E.C. civil charges and say they will fight the commission in court. The lawyer for Kimon P. Daifotis, one of the executives, said his client also lost a lot of money. A person close to the other executive, Randall W. Merk, said he invested an additional $500,000 of his own money in August 2007 and never withdrew any of it. His timing could not have been much worse. (The person did not have permission to discuss the investment on the record.)

That the three men lost a lot of money may be of some comfort to other investors who suffered. They also will be happy that most of the more than $350 million to be paid by Schwab — including its settlement of a private class-action suit — will go to them.

But investors lost $1.1 billion in the fund over the two years it cratered. They will not be made whole. It might help them a bit if Mr. Schwab, Mr. Daifotis and Mr. Merk did not share in the distributions.

The fund is still around, albeit with less than $150 million in assets. A visitor to Schwab’s site now is told that the fund combines high risk with low return.

Unfortunately, that disclosure comes a little late. In the 2007 annual report — the one with the creative definition of maturity — Mr. Merk, then the chief executive of Charles Schwab Investment Management, wrote: “In the end, the basic reasons for keeping bond investments in a portfolio — income and lower volatility — are always worth remembering.”

A version of this article appears in print on January 14, 2011, on page B1 of the New York edition with the headline: At Schwab, Unkept Promise To Investors. Order Reprints|Today's Paper|Subscribe